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Should you pay off student loans early or contribute to your company's 401(k) plan?

July 20, 2016

 

 

People often struggle with the choice of either reducing their current debt or increasing their push to save for retirement. Deciding whether to pay off student loans early or contribute to a 401(k), for example, can be tough for younger workers. It's a financial tug-of-war between digging out from debt today and saving for the future -- both of which are extremely important goals.

 

Managing student debt is now the norm for most younger workers.  According to The Institute for College Access and Success[1], nearly 70% of college grads in the class of 2014 had student debt, with an average balance owed of $29,000. This equates to a monthly payment of about $294, assuming a 4% interest rate and a standard 10-year repayment term. While you are obligated to make that minimum monthly payment, the question we here often is: "Should I pay more toward those loans each month in order to pay them off faster? Or should I, instead, contribute any extra funds to my 401(k)?"

 


In our opinion, the knee-jerk answer should be -- save for yourself first! -- and pay the loans on time, every time, but not faster.  After all, the loans are structured to be retired eventually, and you'll be that much closer to retirement when they are. So, delaying saving for retirement has real costs not only in terms of total savings, but the lost compounded interest those savings could have earned along the way had they been invested.   

 

All that said, the financial answer to this question boils down to how your money can best be put to work for you.

"70% of college grads in the class of 2014 had student debt with an average balance owed of $29,000." 

For example, does your employer offer a 401(k) match. If they do, you definitely should not leave this money on the table. It's free money, and you don't get to ask for it later.  For example, if your employer matches $1 for every dollar you save in your 401(k), up to 6% of your pay, and you make, say,  $50,000 a year, that's $3,000 your boss is just begging to give you, and money you lose if you don't also contribute $3,000 of your own money to retirement.   In this example, at a minimum, you should be contributing $3,000 per year to your 401(k)--about $250 each month--so that you benefit from that full dollar for dollar match.  Think about this for a second.  That's potentially a 100% return on your initial investment. 

 

Even if your employer doesn't offer a 401(k) match, it can still be a good idea to contribute more to your 401(k) before paying down other debts. When you make extra payments on a specific debt, you are essentially earning a return equal to the interest rate on that debt. If the interest rate on your student loans is relatively low, the potential long-term returns earned on your 401(k) may outweigh the benefits of shaving a year or two off your student loans. In addition, for younger workers, time is on your side. The long-term growth potential of even small investment amounts can make contributing to your 401(k) a smart financial move.


So, in our opinion, in many circumstances, unless the interest rate of the loans are extremely high, saving as much as possible (as soon as possible)  for retirement is the better choice, and is secondary to making advance payments on the typical student loan.

 

 

 

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Footnotes:   

 

[1] “Student Debt and the Class of 2014, 10th Annual Report,” The Institute for College Access and Success, October 2015.

 

 

See Disclosures.

 

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